Annual Percentage Rate (APR) and Annual Percentage Yield (APY) may sound similar, but they have key differences that can significantly impact an investment’s expected return.

For investors in lending products like private credit, understanding APR and APY—and knowing when to use each—is essential for accurate return calculations.

In this article, we’ll break down these differences with examples, showing how APR and APY apply in various scenarios. Whether you’re evaluating loans, credit cards, or investment opportunities, understanding these concepts will empower you to make more informed financial decisions.

Key Takeaways

• APR represents the annual cost of borrowing, including interest rates and fees, but excludes compounding. APY, in contrast, factors in compounding interest, providing a clearer picture of potential investment earnings.
• Choosing between APR and APY depends on your financial decision. APR is more relevant for borrowing and investments without compounding, while APY is important when compounding plays a role in your investment strategy.
• Knowing how often interest compounds is essential for calculating APY, as it can greatly impact the total return on your investment.

What is the Difference Between APR and APY?

Understanding the difference between APR (Annual Percentage Rate) and APY (Annual Percentage Yield) is essential for anyone dealing with financial products, as each focuses on a unique aspect of lending and investing.

Simply put, APR represents the cost of borrowing. It’s the annual rate for taking out a loan, covering both the interest rate and any additional fees. Unlike APY, APR doesn’t include compounding interest, making it a useful measure for understanding the actual cost of a loan.

APY, on the other hand, reflects the earnings on an investment. It includes the interest earned and the impact of compounding. The frequency of compounding—whether daily, monthly, or annually—increases the APY beyond the nominal rate, highlighting the potential growth of savings or investments.

Lenders often use APR to show the real cost of borrowing, while banks and investment firms use APY to illustrate how an investment grows over time through compound interest.

How APR and APY Impact Returns Over Time

Understanding the difference between APR and APY is crucial when calculating investment returns. Take an investment offering 5% APR and another offering 5% APY. While these rates appear similar, their returns can vary significantly, especially over time.

Since APR excludes compounding, a $10,000 investment at 5% APR yields $500 after one year. In contrast, a 5% APY, assuming monthly compounding, would yield $511.60 for the same $10,000 investment after one year.

APR Calculation (Simple Interest)

Since APR doesn’t account for compounding, we can use the simple interest formula:

Where:

• Principal = $10,000
• Rate = 5% APR 

So:

Interest = $10,000 × 5% = $500

After one year, the total amount with 5% APR is $500 after one year, for a total of $10,500.

APR Calculation (Monthly Compounding)

For APY, since it includes compounding, we’ll use the compound interest formula:

Where: 

• Principal = $10,000 
• Rate = 5% APY 
• n = 12 (compounded monthly) 
• t = 1 year

So: 

A = 10,000  1 + 5%12 12x1

A = 10,000  1 + 4.167% 12

A = 10,000  1.004167 12

A  = 10,000  1.05116

A = $10,511.60

After one year, the compounded investment with 5% APY yields $511.60 in interest after one year for a total of $10,511.60.

This is $11.60 more than simple interest, APR, calculation.

When to Use APR or APY?

APR is straightforward and works for simple interest situations, like credit card debt or fixed-interest loans. APY, however, is best used when calculating returns on investments that benefit from compounding, such as those where earnings are reinvested. 

At Altify, we target a simple APR of 11-16% on its investments, net of any fees. This target assumes investors will not reinvest their earned interest as investors on Altify by default will receive their interest payments, paid into their account, and can withdraw the funds. 

For investors who choose to reinvest their interest payments, calculating a higher APY would be appropriate. This can be done using a simple online APY calculator. 

In Conclusion

Understanding the nuances between APR and APY is essential when evaluating borrowing options or seeking the highest returns on investments. APR clearly shows the cost of borrowing, making it useful for comparing loans or credit cards, while APY highlights the potential earnings from investments, especially those that leverage compounding interest. 

By making informed decisions based on these metrics, investors and borrowers can optimise their financial strategies and achieve better outcomes.